Sunday, November 25, 2012

Financial journalists across the globe were both surprised and puzzled recently when they heard Christine Lagarde using a strange expression. "You know, it's not over until the fat lady sings, as the saying goes," she told bemused reporters at a press conference in Manilla. Which fat lady, and what does she sing must have been questions going through the heads of many of those present.

Further investigation would have lead them to discover that far from this being some new piece of feminine wisdom that the IMF DG wanted to transmit, the phrase in fact comes from the rather male world of business deals and contact-sport-commentators and is generally used to describe closely contested matches, or deals which won’t be struck till the final offer is actually made.

Ms Lagarde naturally had other things in mind. She was referring to the state of negotiations surrounding the latest Greek bailout review, prior to the handing over of that long awaited 31.5 billion euro tranche the country so badly needs to meet its ongoing commitments. The curious thing about the holdup in this case is that it isn’t the result of a stand-off between the Troika and the Greek government. Last week the Greek parliament passed the final set of budget decrees required by the international lenders to enable the transfer.

No, in this case the dispute is an “internal affair” between the rival parties which make up the Troika, and in particular between the German government and the IMF. The issue is how to leave Greek finances having at least the appearance of being on a stable and sustainable path, which in this case is defined as attaining a sovereign debt level of 120% of Greek GDP come 2020. Delaying the country’s fiscal objectives by 2 years effectively means putting back the theoretical attainment of that objective by the same amount of time - until 2022. Jean-Claude Juncker was willing, but the IMF is digging its heals in. Any new agreement, Ms Lagarde said as she left Manilla en route for Tuesday’s Brussels EU finance ministers meeting, should be "rooted in reality and not in wishful thinking.” Tut tut, Mr Juncker.

So whence this sudden hardening in the Funds position? Well, it may be just a coincidence, but the US elections are now over. Barack Obama need not now preoccupy himself with what a hypothetical exit by Greece from the Euro would do for his campaign. Non-European members of the Fund have long been chaffing at the bit over the extent of the “kid gloves” treatment so many apparently rich countries have been receiving, and have been arguing for a much more independent and tougher approach. Now with the US starting to shift its ground the balance of opinion has clearly changed.

Greece’s debt is evidently on an unsustainable path however you look at it. Just getting through to 2020 isn’t enough, since the following decade is going to be very challenging demographically for the struggling country. Greece needs either a much more substantial reduction in its debt levels, or a negotiated exit from the Euro.

Realists are now pushing this view, but realists are also pragmatic people, they recognize that Angela Merkel has elections looming in the autumn of 2013, and that she can only go so far at this point. So it is simply the principle of the thing that needs to be established now. We can all get down to the real details once Greece fails another review, possibly towards the end of 2013. What Christine Lagarde did make clear in Manilla is that being “rooted in reality” means is that the best way countries in the Euro Area can send a strong and credible signal they remain committed to Greece’s continuing Euro membership is by agreeing in some way shape or form - the formula doesn't matter - to reduce the debt Athens owes them.

As Deutsche Bank analyst Mark Wall so tactfully put it in his latest report on the situation, "The objective of the current round of decisions will be to 'kick the Greek can' beyond the German elections in September 2013".

So it seems to me that later, after the German elections are over, the fuller implications of this initial signal of "realism" can be fleshed out. By that point Greece’s crisis-weary population will surely be ready for neither another year of substantial austerity cuts, nor for yet another year of recession, so a solution will need to be found. Unemployment will likely be over 27% at that point, and with people possibly being asked to grin and bear a seventh year of recession, we may well be rapidly closing in on a "just how much of this can you really stand" type situation.

If the debt pardoning cannot be great enough then Grexit will be on the table as a contemplatable solution. As Citi analyst Giada Giani puts it in the their latest report, "even if a return to a semblance of sustainability is agreed for the Greek debt and the next bailout tranche is released, we doubt this will be the deal that fixes Greece once and for all. We think a Grexit scenario still has a 60% probability of occurring in the next 12-18 months."

Calm Before the Storm?

So, the Euro Crisis is going to be effectively put on the back burner over the next nine months or so, or at least that is the hope in Berlin. Naturally there are no shortage of loose cannons that can come into play to make this hope just another example of what Lagarde calls “wishful thinking”, but even assuming everyone gets the time-out people are hoping for, just what is going to happen when the German election milestone is passed? To the external observer, it does look like fund managers from across the planet are being told one thing (that Germany will then take the bold steps which are so evidently needed to shore up the common currency) while German voters will be voting in the exact opposite belief, even to the extent perhaps of being lead to think that the OMT bond buying programme is merely temporary. So someone is going to be very badly disappointed, and not long from now market participants will have to start placing their bets on who they think that someone is going to be.

But to return to where we started, just who was that fat lady, and what exactly did she sing? Well deeper investigation into the world of urban legends reveals that the woman in question is none other than Brünnhilde, shieldmaiden and valkyrie in Norse mythology, as well as heroine in Wagner's famed and fateful opera Götterdämmerung. As opera fans will remember, when the singing stops the world of Valhalla comes to an abrupt end, as Brünnhilde throws herself on a pre-prepared funeral pyre and in so doing initiates the final destruction the known world. Although the interpretation that this was some sort of "Freudian slip" for what the IMF boss actually fears could happen - namely the Greek Heracles might finally abandons his labours and descend into the nether world of Hades - is plausible and available, I prefer to think it was in fact a match of American football she had in mind. At least that way I sleep better.

Monday, November 19, 2012

The exact origins of the expression are unknown. They are lost back then, somewhere in the mists of time. But the meaning of the phrase is perfectly intelligible. In Spanish "to end up like the Rosario De L'Aurora" (acabar como el rosario de la aurora), means to end up badly. Very badly. The Rosario in question is a procession (of the kind to be seen in this YouTube video) and aurora here is not a woman's name, but the Spanish word for dawn. According to legend, the procession which gave birth to the phrase was characterised by a dispute which developed into an outright brawl during which all those precious sacred artifacts being carried by the devout got unceremoniously destroyed.

One popular theory has it that two rival processions tried to advance in opposite directions down an extremely narrow street, with neither being prepared to give way. Similarities with what is currently happening here in the Euro Area is, of course, entirely coincidental. What with the quantity of alcohol that people wandering the streets in the early hours during fiesta time would likely have consumed, and the fierce rivalry between the two "comparsas", the outcome is surely not that hard to foresee, or that worthwhile explaining. We can leave such details to the imagination of the reader.

But moving forward in time, and while again the versions of the story may differ, there seems to be little doubt that Spain's economy is in bad shape. Very bad shape. Such bad shape in fact that, according to Tobias Buck in a recent article in the Financial Times, it has left most of the countries population "bewildered". Bewildered, and increasingly desperate and despairing, or as blogger Matthew Bennett puts it dogged by the feeling that the modern Spain they know and love "is in danger". Indeed if we aren't all careful, the country could end up in a worse state than the one which befell that legendary rosario.

You know the Modern Spain you love is in danger.

Thankfully, you can still eat abundant amounts of tasty Spanish ham whilst drinking a decent Rioja, and the Spanish national football team is still beating all-comers at international level—a truly world class achievement—but in your heart of hearts, you know a cataclysmic future outcome is a plausible option for a Spanish society that is struggling to adapt to a new world economically, politically and constitutionally.

What happens to a society when tens or hundreds of thousands of its own citizens abandon the country to go and live and work abroad, with the approval of parents, government ministers and even the king? When record numbers of citizens—25%, nearly 6 million Spaniards—are unemployed, with no economic recovery or new jobs visible anywhere on the horizon? When the 12th largest economy in the world is ranked 136 for ease of starting a new business, behind Burundi, Afghanistan or Yemen?

What happens when Spain’s existing national institutions aren’t capable of offering all of its citizens and residents a prosperous existence, or when political leaders steadfastly refuse to listen to their voters’ repeated cries for change and prefer instead to repeatedly lie to the nation, ignoring their own electoral programmes?

Put The Telescope To Your Blind Eye And You Will Surely See Recovery Ahoy!

But while the self-deluded continually claim to be envisioning signs of recovery, the data tell us another story. Almost every indicator we have points to deterioration, and the forward looking ones we have suggest there is worse to come.

The latest in the long line of examples I could cite comes to us in the shape of the third quarter GDP results, announced last week by the national statistics office. Between July and September the economy shrank by 0.3% quarter-on-quarter, or by 1.6% when compared with a year earlier, making for the fifth consecutive period of negative economic growth. This put the Spanish economy back at a level approximately 4.25% below the highpoint achieved in the first three months of 2008, just before it entered the great recession.

But, of course, all of this isn't over yet. At the start of last week the Spanish newspaper El Pais published details of leaked EU Commission forecasts for the country, showing that GDP is expected to decline by 1.5% in 2013, scarcely better than a 1.6 percent drop this year. Growth of 0.5% is then expected in 2014, and even if this result is eventually confirmed, what about 2015? Who is to say we won't be back to minus 0.5% again, or worse? Spain's economy won't be surging back to life again, the accumulated debt problems and continuing competitiveness issues virtually guarantee that, and only those who clutch hold of some kind of "but economies always recover, don't they" quasi religious type of fig leaf can summon the energy to convince themselves otherwise. The data and the analysis almost all point in another direction.

Yet, just like those historical reports that lie behind the rosario legend, this latest piece of economic data does inevitably allow for a plurality of alternative readings, and you can just glimpse a glass half full if what you really want to do is convince yourself that what is so obviously happening to the country actually isn't . Some will make a great deal of play of the fact that the rate of inter-quarterly contraction slowed when compared with the April through June period. Even the EU forecast can be used to this avail, since the annual rate of decline would seem to fall by one tenth of a percentage point next year. So thing are getting better!

Others will rejoin by pointing to the slew of other economic data which points to continuing deterioration, while yet others will argue that the fact the contraction wasn't deeper suggests the possibility that the austerity programme hasn't been all it is being made out to be, with the consequence that the deficit correction process is surely once more well off course. Indeed the EU and the IMF seem to now openly recognise this. Plus ça change!

At the end of the day, however, all of these interpretations miss what is surely the main point - Spain is and will continue to be stuck in depression, and not simply passing through a garden variety recession. Growth may be minus 0.3% one quarter and plus 0.3% the next. Frankly that doesn't change anything. Or at least not anything important. Without a more substantial set of growth restoring adjustments the economy will simply hover between growth and contraction for the rest of this decade, always assuming some major life-threatening event doesn't intervene first. The economy is broken, and there is no hidden hand at work on which to base expectations for an automatic fix. Recovery simply won't happen all by itself. That is to say, if someone somewhere doesn't do something to stop what looks set to happen happening, Spain and its economy can end up a lot worse off than even that famous rosario.

Let's look at some examples of what now seems to be more like a horror than an adventure story.

Credit, Houses and Jobs
The economic crisis afflicting Spain and its economy has many aspects, dimensions and layers, but through the fog three interconnected elements stand out clearly - the availability of credit, the stock and price of houses, and the levels of employment and unemployment. Whatever starting point you chose, the final outcome always turns out to be the same.

The country seems to be trapped in some sort of modern adaptation of the traditional children's game "ring a ring o'roses". There is a shortage of credit in Spain because the economy is losing jobs, causing the demand for and prices of homes to fall, leading banks to accumulate unwanted assets and clock-up a growing number of bad loans which in turn makes them reluctant to advance new credit due to the fear of have to assume even more losses. But we could equally say that the economy isn't creating jobs precisely because of this shortage of credit, and that the rising unemployment is affecting the housing market. Or, if we are still not satisfied we could put it like this: the fall in house prices is reducing demand for houses, and weakening household consumption (via the wealth effect - 75% of all household saving in Spain is held in the form of property). This drop in consumption is causing the economy to contract, with the result that it is constantly shedding jobs leading the banks to incur even more losses.

Whichever way you look at it these three interconnected components lie at the heart of the Spanish malaise. There will be no resolution of the Spanish "problem" without a turnaround in all these areas, and at one and the same time. Kick-starting the Spanish economy means inducing an expansion in the number of those employed, a freeing up in the credit gridlock and establishing a bottom in the downward march in house prices. At the present time none of these objectives are anywhere in sight. Unemployment is rising, and will continue to rise in 2013. People are leaving the country, credit is falling, and house prices have just had one of their biggest interannual drops since the crisis began. This dynamic produces a vicious circularity which puts the country at risk of enduring the same fate as all those generations of children who have participated in the aforementioned ritual, namely that the climax is reached when everyone cries A-tishoo! A-tishoo! and then lies down.

Water Water Everywhere, But Not A Drop To Drink

The question of credit flow is an especially complex one, since it is both cause and effect of the depression. Linear thinking will always have trouble with this kind of phenomenon. The banking system cannot freely supply credit since such a significant part of its balance sheet is "encumbered" with existing loans, some of which are already none performing. But there are many more which are in danger of becoming "troubled" if the crisis continues through the years ahead. Yet it is this very encumberment which virtually guarantees the crisis will continue. The loans in question are not only those made to property developers (many of these have in fact already been drastically written down). They are also syndicated loans to large companies, loans to small and medium enterprises, and loans to individuals for residential mortgages. As it is none of these portfolios are exactly going well, but the quality of the loans within them will continuously deteriorate for as long as the listless drift continues.

In addition, we need to remember that during the "good" years Spains banking system became considerably "overleveraged" - that is it gave an excessive number of loans in relation to the system's deposit base - in much the same way the Irish one did. So as well as working off distressed loans, the Spanish financial sector needs to reduce its leveraging which means (without a substantial increase in the volume of deposits) it has to cut back on lending. Naturally the kind of deposit flight Spain's banks saw in the first half of this year doesn't help matters.

So while the creation of the bad bank and the recapitalisation of the entire system will help clear some of the worst rubbish off the balance sheets, this doesn't necessarily mean that the clean up will lead to a flow of new credit, and indeed what has happened in Ireland (see chart below) tends to confirm this view. Irish banks handed over a large part of their distressed property assets to the bad bank NAMA, yet the interannual loan numbers continue to be in negative territory, just like the Spanish ones are.

To top it all, despite the fact that the country's banks had a net 378 billion Euros outstanding with the ECB in September credit is still not cheap.

Wholesale funding (where available) still comes at a hefty surcharge, and building the deposit base doesn't come cheap in a country where prices are rising at the rate of 3.5% a year. Typical fixed-term deposits now pay around 4%. Hence, according to the most recent ECB data (August) for lending rates to small and medium enterprises, German companies seeking a loan of €1million over a term of between one and five years typically pay something in the region of 3.8% – a record low for the Euro era – while their Spanish equivalent is paying 6.6%, the highest level since late 2008 when central banks cut rates after Lehman Brothers collapsed. So it isn't only wage costs that need to be reduced in Spain, capital costs need to come down to. This is naturally one of the objectives of Mario Draghi's OMT programme, but Mariano doesn't want to play ball, a strategy which may seem politically convenient but which comes at a high price for Spanish companies and those forming part of Spain's growing jobless mountain.

The second major issue facing Spain is how to stop the fall in property prices. Residential housing has seen falls now for almost 5 years, and prices are down around 30% according to real estate valuers TINSA, dropping by an annual 12.5% in October. Put another way, prices have fallen from something over 2000 euros a square metre, to around 1500. Spain's banks hold roughly 600 billion in home mortgages, and back of the envelope calculations suggest that once prices hit the 1,000 euros a square metre level the whole system (on aggregate) will be in negative equity - that is that homeowners will be standing on values in their property portfolio below the outstanding quantity owed in mortgage loans. At that point a critical moment will be reached, with the danger of implosion being much greater than "non negligible".

Spanish property prices have been being supported by a combination of three factors.

1) banks holding repossessed assets on their balance sheets
2) the illiquidity of the market, with very few transactions in new property taking place
3) a completely unfair distribution of risk between property developers (who can simply give back the keys) and those who bought the properties they built at the ludicrous prices they charged (who can't).

The nationalised banks are now set to move their "troubled assets" off balance sheet and into the newly created bad bank, Sareb. Although many questions still remain about the way Sareb will operate, its creation is unlikely to produce a turning point in the housing market, discounts may still not be sufficient to attract buyers in large numbers, and it is not clear how the mortgages those buyers who do appear will be financed.

Mortgages are not freely available in Spain, the volume of credit extended for house purchases is falling steadily year by year (see chart above) and attractively priced mortgages are normally only available to those buying properties on the balance sheet of the issuing bank. Those who seek mortgage finance for other property normally have to pay a hefty surcharge. Since Sareb will not be a bank, it will not have "own funds" with which to grant mortgages.

In the meantime Spain's unemployment continues to rise, hitting a record 25.8% in September. It is hard to say where this will peak, but the level looks certain to hit 27% in 2013. More importantly, simply getting the level back down to 20% again looks set to be a mammoth task, and one which is unlikely to be achieved this side of 2020. So many more years of pain certainly await the country.

One of the reasons the unemployment rate should peak reasonably soon is that people are now leaving the country in growing numbers. With 52.9% of the under 25 population who would like to work now unemployed a lot of young people are simply giving up and voting with their feet. According to data from the national statistics office, in June this year a net 20,000 people left the country. That may not sound like much, but it is a rate of one quarter of a million a year, or a million every four years. More worryingly the rate of outflow is on an accelerating trend (see chart below).

Natrually this wouldn't matter so much if the Euro Area was one single federal state, since health and pension costs would be shared across the region, so it wouldn't matter whether people were paying taxes or social security contributions in one place or in another. Indeed such movement would be a rather positive sign of the existence of a single labour market, and labour force flexibility. But the Euro Area isn't a single state, and contributions and costs aren't shared. So some countries risk becoming unsustainable.

Several years ago, and according to UN estimates Spain looked destined to become one of the oldest countries on the planet come the 2020s. That picture changed dramatically during the first decade of this century as some six million migrants came to live in Spain and the population shot up from 40 to 46 million in just a few years.

Before the arrival of the migrants Spain's population was virtually stationary. Really it is impossible to give any sort of precise forecast at this point of the Spanish population in 2020, or the rate of ageing, since the size of the population is so obviously path dependent on the evolution of the economy. It shot up as the economy was booming, and now it is falling back again as the country languishes in depression. It is almost a certainty that the population will continue to fall (births are also down) but how far and how fast depends very much on what happens in the job market.

This population exit has two important consequences. In the first place it reduces the future demand for housing, thus making it even more difficult to stabilise the market. And in the second place it means the pension's system, which is already becoming a significant drag on the fiscal deficit will continue to weigh ever more heavily on public finances, and will surely lead to ever more urgent and drastic modifications to the parameters in the country's pension system at some point in the future.

Exports Looking Good

Well, that is all obviously extraordinarily bad news. But Luis de Guindos (the country's economy minister) would retort, that some things are going well. Exports, for example, have put in a strong showing in 2012.

Not only that the goods trade deficit is reducing:

The current account has also improved substantially, and in fact went positive in July and August for the first time in many years.

The improvement in the current account is evidently good news, and it is even better news that it is accompanied by a rise in exports, and not just a fall in imports as consumption declines. But the disappointing reality here is that even despite these improvements Spain's economy is still contracting, contracting and running an 8% fiscal deficit. The reason for this is that Spain's export sector is still way too small for the work it has to do. I have been over these arguments time and time again, so I don't propose to go into them here and now. You can find the issue thoroughly discussed here (from June 2011), and here (from August 2010), and all I can say is that the arguments I use are just as valid today as they were then. I'm not sure how many others can say the same.

With the private sector deleveraging, and the government trying to reduce spending the only thing which can really grow to the economy is the export sector, but until that is bigger the impetus given to the economy won't be sufficient to offset the drag from the other two sectors, and the economy will hover around the zero growth mark. One sign that things were really getting better would be a surge in investment, which would be reflected in demand for capital goods, but as can be seen in the chart below this demand just isn't there.

Where Is The End Game?

The future of Spain is now very hard to see (so "que sera, sera"), and with it rests the future of the Euro. Interest rates on Spanish debt may well come down eventually if Mario Draghi starts the OMT bond buying programme, but as I argued in this post, intervention from the ECB alone isn't going to solve the Euro Area's underlying problems, only closer political union will be able to begin to address these, and that seems farther away than ever (or here and here). At the present time everything seems to be on hold, with Mariano Rajoy on the one hand reluctant to formally ask for a bailout, while Angela Merkel on the other is in no rush to do anything till after the German elections are over. Meanwhile those without work, and those about to be evicted from their homes just have to wait and see.

Even the deficit seems to no longer be a priority. Olli Rehn announced last week that Spain will not be asked to apply any additional austerity measures until at least the end of next year, despite the fact that everyone acknowledges the country will substantially miss its deficit targets both this year and next. The most recent EU Commission forecasts see an 8 per cent deficit this year and 6 per cent in 2013, but even these may be to generous now that the straps are off.

Obviously this loosening in the policy stance could be seen as positive, if you thought that measures taken over the next two or three years would return the country to sustainable growth, but the sad reality is that the vast majority of the structural reforms being enacted are only likely to have marginal effects on the countries overall economic performance, and the one that could, the labour market reform, was described by the ECB in its August bulletin as being too little coming too late. As the bank puts it, "the authorities ﬁnally approved in February 2012 a far-reaching and comprehensive labour market reform that could have proved very beneﬁcial in avoiding labour shedding if it had been passed some years ago." As it is, the bank continues, "given the low level of competition, further signiﬁcant reductions in unit labour costs and excess proﬁt margins are particularly urgent....To achieve this, ﬁrst, ﬂexibility in the wage determination process has to be strengthened, for example, where relevant, by relaxing employment protection legislation, abolishing wage indexation schemes, lowering minimum wages and permitting wage bargaining at the ﬁrm level".

In other words, the country needs to initiate some sort of internal devaluation process to restore competitiveness, something I have and others been arguing for over several years now. But looking at the political landscape inside Spain after five years of unending crisis, this policy is extremely unlikely to be implemented as the political will just isn't there. The recent attempt by the Portuguese government to try something similar was over in a week on the back of strike and protests. Too much time has been lost, and too much weariness has set in. So the rot stays stuck in the wood, and one way or another we are on collision course.

But the biggest catch in the deficit loosening agenda is the impact this will have on Spain's debt trajectory. As I argued in this post, putting the submerged part of Spanish government debt on the table was always going to be a risky move, since the debt level could rise dangerously near the critical 100% of GDP mark, above which no one in this crisis has yet risen and come back to tell the tale.

Well next year it looks very probable we will now cross that particular threshold, and what's more Spain's deficit will continue adding to the level for several more years to come. In addition there are still unquantified risks in the financial sector. Despite all the lauding of Mario Draghi's OMT programme, it could well turn out that Germany backing off from the June agreement on mutualising the bank recapitalisation costs could in fact mark the critical turning point in the debt crisis. One of two groups of people are going to be bitterly disappointed after the coming German elections - German voters who are being promised they will not have to bear part of the costs of recapitalising the Euro Area's troubled economies, or investment funds who are being constantly reassured in the background that once the elections are over this is exactly what is going to happen.

So this year Spain's banks are going to be adequately capitalised, but what about in 2014, or 2015, or later if the crisis drags on and on? The new banking union may well be in place, but if the principal of not mutualising legacy debt problems is maintained, then it is hard to see how the losses on debt obligations which are currently being rolled over - like the large number of residential mortgage resets which are being used to avoid eviction - are going to be funded once the finally have to be recognised.

This week the tragedy of Spain's ongoing evictions drama has been in the news, (and here), and a new code of practice for evictions has been put in place by the government. But this is only scratching the surface. If, as seems probable, house prices continue to wend their way down then there really will be no way round the passing of some sort of new personal insolvency law to enable people to write down part of their mortgage, as we have seen in Ireland. The days of full recovery in Spain are numbered, since the social clamour, as in Ireland, will just become too great. Interestingly, ratings agency Moody's pointed out that in Ireland negative equity rather than unemployment was now becoming the main driver of mortgage default (and here) - and indeed they predicted that one in five Irish mortgages would be in default by 2013. This is interesting because the models used by Oliver Wyman and Roland Berger to stress test the Spanish banking system do not use negative equity as a parameter, relying mainly on unemployment levels and GDP movements for their default estimates. Spain's entire mortgage system is likely to fall into negative equity on aggregate within 2 or 3 years, meaning the capital requirements could then well be very different from the ones we are seeing now.

Then there are the regions. On the worst case scenario Spain could see a 20% drop in GDP as Catalonia exits stage left (elections are being held on the 28th - I have written extensively about this here, and the separatist case is put here), and if the Spanish government insists on carrying out its threat to veto continuing EU membership for any new state which might be created, the reality is that the rump country's debt level will surge to 125% of their remaining GDP, even assuming there aren't worse dislocation problems for the economy. Naturally one would assume that the Spanish government would negotiate rather than shoot themselves straight in the foot (typical prisoner's dilemma type stuff this), but you can't be sure, and maybe you should take them at their word. It doesn't matter it seems if the whole Euro project falls apart, if the Catalans vote to be independent they will not be permitted to remain in the EU.

Naturally, intransigence is seldom a good policy, and investors who want to take an interest in the issue might ask Spain government representatives who are locked in to their "total veto" and blocking strategy how, if they ever had to implement it, they intend to get their exports out to Europe. The lines in blue in the chart below show the national rail network, and those who know some geography will quickly see that there are only two connections with France, one through Catalonia and the other through the Basque country. I have no idea whether Catalonia will be in or out of Spain 5 years from now, but what I am pretty sure of is that if the Catalans left the Basques wouldn't be far behind.

So there we have it. What we have is a country where not only are people of working age leaving in growing numbers, whole regions may want to go. A country where deficit numbers have been flouted time and again while bank interventions have been consistently implemented using the principle of always try to do too little too late. The country suffers from what the ECB calls deep competitiveness problems, yet there is not a single proposal on the table at present which would do anything substantial to correct this.

The pension system is spiraling quickly into a substantial structural imbalance, yet the government will hear nothing of any deep long-lasting pension reform. I could go on and on. I would like to be optimistic, but five years of watching this train crash in slow motion have left me with the feeling that this one now has no solution. The country's political leaders just aren't up to the levels of complexity involved (see this excellent summary of some of the "matters arising" in this regard from César Molinas here, and Europe's leader not only drag their feet, they stick their heads in the sand at the same time. The exact details of how and when escape me, but this situation now has all the hallmarks of ending up in the same way as that legendary Rosario whose untimely demise gave the title to this post.

Monday, October 22, 2012

Legendary hedge fund supremo Ray Dalio is in ebullient mood. Following a series of moves by Mario Draghi to underpin European government financing Dalio told Bloomberg
that, in his opinion, the euro will now “likely” stay together because existing growth constraining austerity measures will henceforth be balanced by money printing over at the European Central Bank. His statement was, of course, a response to ECB President Draghi's save the Euro pledge.

This story starts back in July, when Mario Draghi calmly informed a London investors conference that, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Since that time, of course, this gamechanging statement has been qualified and clarified, and re-qualified and re-clarified innumerable times, but still the essence remains unchanged. The ECB President wasn't talking, remember, about any specific programme of bond purchases or exceptional liquidity measures, he was talking about doing "whatever it takes", and Ray Dalio for one is taking him at his word.

What Bridgewater's founder was getting at when he made this assessment is that there is now no meaningful limit being placed on what the ECB might eventually do. Naturally there is the mandate to work around, but the mandate can always be changed if Europe's political leaders see fit, and who at this point in the crisis still doubts that if needs must they will see fit.

Indeed in many ways it is easier to envision a change in the EU Treaty to tweak the EU mandate than it is to envision one to establish, for example, a full fiscal union. Especially now the ECB has become the in-tray into which all the politically unpalatable and thus unresolvable issues ultimately get dumped. The most recent example of this is the suggestion that Spain applying for a precautionary credit line would be the ideal solution to the country's current dilemma since no money would actually need to change hands, making the move easier to sell to the German parliament.

No money would need to change hands because Mr Draghi and his governing council would be stepping up to the plate alone. This outcome looks and feels rather different to the "burden sharing" approach outlined by Mario Draghi during the August ECB press conference.It looks and feels different because it essentially is different, even if the two possible modalities of ESM action were laid out from the start. What wasn't envisioned was that NO ESM money would be used to buy bonds. That the ECB would be acting alone.

Of course any talk at this point about the forthcoming Spanish bailout means navigating in an ocean of uncertainty, but as far as we can see at the moment the end result of all the negotiations, crying wolf and procrastinating seems to be that the ESM won't be buying bonds in the primary market.

Instead some of the Euro Areas financial institutions (acting as brokers for the ECB) will do so and then re-sell them on to the central bank. This differs in substance from what some have referred to as ECB LTRO-style "QE by stealth" in that the central bank would be owner of the bonds, and not simply holding them as collateral. While adding considerably to central bank risk this procedure is seen as being politically more palatable in the north, and limits the sovereign bond/bank capital "death spiral" many worry about in the south, since it avoids the need for periphery banks themselves to hold more bonds on their balance sheet.

But whichever way you look at it we will still see significant bond purchases, thus maintaining a kind of strange fiction that Spain still remains "in the markets". Obviously, without ECB support in the form of LTROs and the OMT the country would be absolutely incapable of financing itself. So perhaps a better way of putting it is that "the ECB is in the markets" and hence Spain is able to finance itself.

We will leave aside at this point the rather byzantine issue of whether or not these purchases will constitute "money printing", since with the large quantities of money core European banks have sitting on deposit at the central bank the question of whether or not the purchases are sterilised seems to be a totally academic one.

Waiting For The Bailout That Never Comes

As London Thomas suggested in the New York Times recently, the classic work of theatre that is currently being performed on the Spanish stage does not come from the portfolio of Calderon de la Barca, but rather from an Irishman, Samuel Becket. It is entitled "Waiting For Rajoy". However, unlike the original this modern adaptation is unscripted, and resembles more a Cassavetes film where the actors constantly improvise. Naturally the markets are unsure how to trade the situation, but with the passage of the days, weeks and even months I am sure they are steadily learning and adapting.

In recent weeks an almost enless supply of ink has been spilt in the press about the kinds of conditionality which might be applied in the event of a bailout. Naturally there are questions oustanding which the Troika would like to address with Spain - the seriously needed pension system reform, for example, or the across the board wage reduction solicited by the ECB in its August bulletin - but this doesn't seem to be the priority at the moment. The number one objective appears to be getting a firm grip on a country which has proved more slippery than a conger eel when it comes to holding it down to firm commitments.

But, even if we are not party to the intimate conversations which take place on a daily basis between Mariano Rajoy and his chief economic adviser Alvaro Nadal (seen together in the photo below) it does look very much like Spain has been trying to play hard ball with Berlin. In the short term this strategy was used to some effect in Los Cabos (given the surprise element involved) and then subsequently at the June EU summit. However it now seems that this particular window was firmly closed by Angela Merkel at last weeks meeting. Over the weekend it must have been back to the drawing board time at the Moncloa, and the whole world is now waiting to see what the new approach will be.
Prior to this I can almost imagine the tenor of the conversations which have been taking place. "Look Angela, cariño, you must have read your Margaret Thatcher. I don't actually pay these blasted interest costs out of my own pocket, you understand. They are supportable, at least for the time being. We are in no rush." Nervousness can only have been growing at the other end. The nearer we get to the German elections before the bailout comes, and the more deteriorated the Spanish economy at that point, the worse the headache for the CDU.

Arguably Mario Draghi's verbal intervention in the Bond markets has been almost too succesful. He has brought down interest rates without actually doing anything. Probably this is one of the most successful interventions of its kind in recent history.

But the result is that Spain is in no hurry to receive yet another Memorandum of Understanding, not to mention Italy where there is absolutely no interest at all. So we all finally got a free lunch, didn't we?

Well no, not exactly. The ECB is now committing the worst of all sins (according to the version of biblical law to be found in the EU treaty) and helping monetise Spain debt. Even worse, it is doing so with only a virtual intervention. There is no conditionality, and no support measure to withdraw, so no possibility of using a threat to do so. Mario Draghi can hardly go to the next press conference and say, "since there are no takers, the OMT programme is now formally closed".

Meanwhile Spain can continue to go happily along ignoring its EU deficit commitments, since there is no programme, there are no conditions and no sanctions, and the Spanish government are fully aware of just how reluctant both the IMF and Germany are to publicly criticise the country. No one wants to inflict the kind of reputational damage that has been uselessly inflicted on Greece.

Investors, on the other hand, don't want to get "burned" by Mario Draghi - intervention is, after all, just a phone call from Rajoy away, so they do the intelligent thing and stand back on the sidelines. Waiting for Godot (sorry Mariano Rajoy) to decide.

Is this a good outcome? Only if you think Spain is headed to some nice place to be.

So, since the EU has already approved Spain's adjustment programme, looking at the balance of forces and balance of interests I now think it is unlikely very stringent additional measures will be required when finally the big day comes. But this isn't the point. There will be a Memorandum of Understanding, there will be supervision, and there will be reviews. This is what this tug-of-war is all about. This is why Angela Merkel went before the Bundestag last week to explain that she would propose the EU seeking powers to intervene (regardless) in countries who habitually fail to comply. She didn't spell out S-P-A-I-N, but she didn't have to. When the next MoU is nicely in place failure to comply with the objectives which are laid down (highly likely) will then trigger more measures during the review process, as we have seen in Greece.
So there will be plenty of opportunity later. What the Troika representatives want at the moment is to get their claws on, and firmly locked into, their prey.

As I say, the bailout one will not be the first such MoU Spain's present leaders have signed, and with progress on determining bad bank asset handover prices painfully slow, while progress on the "burden sharing" involved in the preference-shares-haircut is seemingly non existent, the men on the other side of the table will surely now be adopting a "once bitten twice shy" approach. Troika representatives are caught between the rock of having to talk up Spain and the hard place of coming to terms with the country's continuing non compliance and deteriorating reputation. I am sure Alvaro Nadal is well aware of this, hence the hard ball, and hence the leverage he is able to apply. Contagion, what contagion?

But moving away from Spain and returning to the opening theme: Ray Dalio's ebullience. The whole issue of the OMT is mere detail, but a tiny comma in the already voluminous history of the Euro Area crisis. What has market participants really whetting their lips is the idea Mario Draghi is willing to do anything, literally anything (within the mandate, but then, if things get desperate what exactly does that mean?) to save the Euro. And believe him, it WILL be enough. If you follow my line of argument, what was meant as a threat becomes a promise. Just imagine how male eyes light up when a woman says she is willing to do absolutely anything for him to save a relationship (or start one). (Incidentally this should not be read as displaying gender bias. No woman would still, in this day and age, believe any man who said the same, at least not unless she wanted to).

So investors have backed off on periphery spreads, and on the Euro. Gravy there will be. Enough to go round everyone. But leaving all that aside, what about Ray's stronger line of reasoning that the promise of all this market fun changes the outlook for the Euro in the longer term? Does it hold?

Or Mario's promise, is it valid? Does he really have it within his power to deliver? Many men promise before the altar that they will be faithful to their wives. Often they aren't. Later some of them learn you shouldn't make promises you can't keep. Can Mario keep his promise?

Let's see.

Deactivating the alarm system, not defusing the bomb.

Perhaps the view of the Euro as some kind of unexploded bomb just waiting to go off isn't a new one, indeed in my Dr Strangelove CNN blog post I have already likened the currency union to the famous "Doomsday Machine", designed in a way which means it will eventually blow up, but also designed in such a way that any attempt to disarm it will produce a similar outcome. But tired as the metaphor may now be I still think that it is a valid and useful one since this is still exactly the situation we are all in.

One of the peculiar things about the Eurosystem is that, just like any garden variety virus that surreptitiously enters your computer hard disk, it has the power to systematically disable all the potential warning signals which could alert you to impending danger.

Perhaps the best example of this unsung virtue has been the way in which central bank FX reserves - a traditional indicator for up and coming balance of payments problems - were rendered all but irrelevant, even though there were in fact no joint and several agreements in existence to guarantee the external debt of any of the participating, but independent, sovereigns. We all now know what got to happen next - countries which had been sustaining unsustainable current account deficits suddenly found themselves with funding problems associated with massive balance of payments crises.

It was at this point that financial markets stepped in to replace an EU system of governance which had been shown to be incapable of either controlling or regulating dysfunctional behaviour on the part of the participating member state governments. At first these moves were welcomed, especially at the central bank, since they had the potential to force the reluctant back into line. But eventually matters got out of hand, and now those very market forces which were once seen as the cure have become part of the problem.

So what do we do? We disconnect the cables (via OMT) which served as the transmission mechanisms for the warning signals being sent by the markets, that's what we do. This naturally puts a break on one "self fulfilling" component of the financial crisis - the one which follows the reasoning chain whereby excessive interest rates on excessive debt can drive a country into insolvency, while fear about the possibility of such interest rates in and of itself drives up interest rates, sending the country over the cliff in any event. Clearly, given this analysis, what you need to do is disconnect the worry factor. Some mistakenly call this "restoring confidence".

So the central bank intervenes to buy government debt, and stop interest rates becoming excessive, then things are just fine, aren't they? But what about the excessive debt which caused the surge in interest rates in the first place? And what about the fact that it is not sustainable. And then there is the lack of economic growth which was producing the fiscal deficits in the first place. Are these problems fixed by the bond buying programme? Of course they aren't. That's why people talk about OMT buying time, and why I talk about deactivating the alarm system. The bomb has still to be defused. But where are the bomb squad? Oh yes, I forgot, they are called the "men in black", and a good job they have been doing of it in Greece.

Printing Money Is Inflationary And Good For Growth?

But let's leave all these secondary issues to one side, entertaining as they are, and go right back to Ray Dalio's best and strongest argument (since I'm sure he agrees with much of what I have just said). The heart of the issue is that Mario Draghi has vowed to do enough, and enough seems to have no limits. So what could the ECB do if we really put our imagination to work on the issue? Well like Ray argues, they could print money, lots of it, even to the point of doing it helicopter style. Those people who think the ECB is already printing money (which they aren't necessarily doing when they increase their balance sheet) ain't seen nothing yet. That's what the "it will be enough" promise means. None of this is in the mandate yet, naturally it isn't, but it could be, and it would be much easier to put more in the mandate than it would be to keep going to the German Parliament to ask for more money. So it could, and most probably will, happen.When you're crossing that rope bridge and it starts to creak and sway then you just have no alternative but to continue moving towards the other side. We have all seen far too many movies about what happens to the people who try to turn back.

As the US saw in Vietnam, the deeper you get in the harder it is to get out, since you plough-in ever more resources simply to go the course, and the losses you would have to accept to leave keep growing and growing, so you keep deciding to do whatever it takes.

So let's imagine this is what happens, and the ECB really goes to the imaginable limits and beyond.

Will it work? Will it be enough? Well this is where I think I find a flaw in Ray's argument, and it is a very common flaw to be found in the thinking of those educated in the US monetary tradition. Ray is assuming the ECB's eventual "money printing" will produce inflation, and that this inflation will help burn down the debt (often today this is termed "financial repression"). Whatever the pain this entails for bondholders, since in this case it is the central bank that is going to be the main bondholder (in our imaginary thought experiment) the outcome may not seem so objectionable from an investor perspective. After all, there are other assets they can get into.

Inflation, always and everywhere, so the argument goes, requires money printing to happen (whether via private or public debt), and in fact it seems to be the case of so far so good, it is almost self evident.

But is the argument symmetrical? That is, does it work the other way round?

Let's give an example. If I want to suffocate myself I need to deprive myself of air. If I don't deprive myself of air I won't suffocate. Fine. And if I deprive myself of air, does that mean I will suffocate? The answer is it depends, the absence of air is a necessary but not a sufficient condition. I need more conditions to be able answer adequately, even though I find it impossible to imagine myself suffocating without a lack of air.

Something similar happens with the inflation and money printing argument. It is unthinkable of having inflation unless someone somewhere is printing money, but does that mean that printing money always and everywhere leads to inflation. No it doesn't.

Worse, in one developed country after another across the globe a lot of money printing is going on, we just aren't seeing the inflation. Why could this be?

What's Going On In Japan?

Well arguably we have a canary in the coal mine here, since Japan has been printing money for more time than I care to remember, and we still see no sign of inflation. Quite the contrary, the country is plagued by deflation, and by the permanent threat of relapsing into recession. So, in this case at least, printing money is not self evidently being inflationary, neither does it seem to be working wonders for growth.

Really Japan is quite a remarkable case, since neither fiscal nor monetary policy seems to be working to achieve the anticipated results. This year Japan will have a fiscal deficit of around 10% of GDP and gross government debt will hit 235% of GDP, yet the country is still struggling to find growth. Instead of reiterating old dogmas (whether they come from Keynes or from Hayek) more people should be asking themselves what is happening here. This is not a simple repetition of something which was first time tragedy and is now second time tragedy, it is something new, and could well be a harbinger for more that is to come, elsewhere. Oh, why oh why are economists not more curious?

At the start of this century, at the end of the internet boom, some economists were warning that other countries could end up like Japan. Ten years have now passed and they have. ZIRP was once an oriental curiousity, now it is the central banking norm, and there are few signs of early exit.

Will Europe Follow Japan?

Basically I think it is only necessary to ask this question to have already found the answer. If Japan's demographics have got some important part to play in the drama which is unfolding there, then it is Europe which is most likely to follow, since the continent's demography is the closest to the Japanese one. Printing money would not be inflationary on the periphery, because there is little solvent demand for credit to generate it, domestic demand remains depressed and this situation isn't changing in the foreseeable future. And it won't be inflationary in Germany, because German domestic demand is just as exhausted as the Japanese variety is in terms of becoming a driver of the economy there. Indeed some peripheral economies have such rigid labour and product markets that headline inflation has stayed above that in Germany almost throughout the present crisis. Naturally, this is hardly good news.

So Will The Euro Likely Stay Together?

Which brings us to the crux of our problem, will money printing at the ECB (lot's of it, helicopters galore) save the Euro, or simply put back the "sell by" date? Really at this point in this blog post I don't want to reiterate the arguments I advanced in my Wolfson Prize entry, but I do consider they are more valid today than they were at the time I wrote it. The core of the issue is this. All participants ahve sunk costs from participation (whether hidden or self evident) which makes it very difficult for members states (at either end of the spectrum) to actively take the decision to leave.

On the other hand, few are convinced that the measures taken to date will actually resolve the underlying problems. They have simply stabilised the situation, and bought time. But time to do what? For the ECB to print money, if Ray Dalio is right. But as I am suggesting, the money printing will not resolve the issue, but will simply buy even more time.

However, when we come to consider how the story will end, many of the traditional versions of the future seem to have been disactivated. Countries will not leave in an orderly way, and markets will not be able to win the war with Mario Draghi. Ratings agencies remain a problem, but at this point they are unlikely to be decisive. But let's step back a bit. The Euro is a political project, and will sink or swim politically. Indeed, perhaps the most perceptive critic of the Euro experience in this sense has been Marty Feldstein, since he took the view from the outset that while the intentions of Europe's leaders was to use the common currency formula to bring the continent closer together politically, a more likely outcome would be that it drive the member countries apart.

This, indeed, seems to have been an insightful analysis, since even while Europe's leaders give the impression of unity, what is actually going on is a constant process of, often bitter, haggling (video link here). Haggling in which moral hazard type threats play a not insignificant part.

And the issue doesn't stop with the (often visible) disagreements between the various leaders, there is a growing distance between politicians and the voters they represent. The world's press are making great play today of this weekend's victory by Mariano Rajoy's Partido Popular in the Spanish region of Galicia, but perhaps the most significant point about these elections is that around half the voters didn't vote. Another example of a similar disconnect would be Wofgang Munchau's recent description of Bundesbank president Jens Wideman as the unofficial leader of the German opposition. So even if Europe's leaders give the appearance of moving closer together, it is quite apparent that the people they represent - whether in the core or on the periphery - are moving farther apart. The classical fault lines of European politics are disintegrating, and democracy is weakening not being strengthened.

To Vote Or Not To Vote In Catalonia?

The most recent, and perhaps clearest, example of this process is to be found in the growing tensions between Catalonia and the Spanish central government. This situation has more general interest for the current evolution of the Euro Area than the simple desire of one of Spain's regions for independence. It has more significance, since the frustrations currently being felt in Catalonia stem from the situation of being one of Spain's richer regions and having to bear what is perceived as being more than a fair part of the cost of the failure to resolve the Euro crisis. Catalonia is a net contributor to the Spanish fiscal system, and wants to make, at least, a smaller net contribution. The situation has been brought to a head by the fact that the region's income-to-debt ratio has risen to the extent that government bonds are ranked at junk status by ratings agency Standard & Poor's. Shut as it is out of the markets Catalonia has been forced to ask for a financial rescue from the central government, a rescue most Catalan's consider to be ridiculous given they feel they are only asking for some of their own money back.

Catalonia's economy has collapsed along with that of the rest of Spain, but the debate becomes a particularly poignant one given the growing feeling of desperation in the face of the inability of Spanish governments of varying political complexions to take the steps necessary to move the country forward. This frustration is now coupled with the growing awareness that more and more austerity is not the formula needed to restore the region to economic growth. As former
Catalan President Jordi Pujol put it in an interview with the FT's David Gardner, “Europe without solidarity would not be possible, but at the same time an excess of solidarity would make Europe impossible.”

He was re-iterating here the view of German foreign minister Guido Weterwelle, to the effect that German pockets are not bottomless. What Mr Pujol was inferring is that Catalan ones aren't either. Naturally behind the Catalan independence drive there are also many identitarian issues, issues which are not easily soluble and which are making for a highly combustible environment inside Spain. But underlying the independence debate there lies a much deeper question. If Europe is moving towards a deeper banking, fiscal and political union, but moving far too slowly, why should an unfair share of the burden fall on the richer areas of the countries in the greatest difficulty? Why should more of the burden not be shared more equally and more quickly. This is not a uniquely Catalan problem, since similar issues are arising in Belgium (Flanders) and Italy (the Veneto among others). Europe is a continent of nations, and the Euro crisis is opening up the fracture lines.

My feeling is that market participants are not taking all this too seriously, and that could prove to be a risky bet. The consensus view was recently expressed in a research report from UBS analyst Matteo Cominetta (summarised by CNBC correspondent Liza Jansen here). The title of the report - Can Catalonia leave? Hardly - is suggestive, and reflects what I perceive to be the present market consensus.

The ins and outs of the issue are complex. Who, for example, would end up with responsibility for Spain's massive debt burden in the event of separation? Probably Spain it seems, unless it were willing to recognise the new state. In the event of non recognition, what sort of bailout would Spain need, and would the EU be willing to provide it if Spain didn't want to recognise its new neighbour? Would an independent Catalonia be inside or outside the EU and the Euro? This is at present unclear, the legal issues are tricky, but I think it should be remembered here that the ECB's initial legal report on Euro exit concluded that a country leaving the common currency would need to exit the EU, and I think there is now a consensus that this wouldn't need to be like this.

Largest of all looms the question of whether the new country (were it to exist) would automatically belong to the Euro, and have access to Eurosystem liquidity. Common sense says it would, whatever the letter of the law, since the region has a financial sector in the region of 500 billion Euros (or 2.5 times Catalan GDP - ie significantly larger than Greece) and some, at least, of the institutions concerned could be considered systemic. So unless you want systemic institutions collapsing........

Perhaps Cominetta's clinching argument (for him) is that the Spanish government has the legal right to prevent a referendum, or veto any forthcoming law on popular consultations (of the kind which just took place in Island). In fact, to prevent an "irregular" consultation the Spanish government could go further. As Cominetta points out, according to article 155 of the Spanish Constitution, Spain's central government has the power to stop a vote from going ahead if “a regional government does not comply with constitutional law” or “acts against the general interest of Spain.” “The Spanish government could even suspend Catalonia’s regional government".

Well, that's fine. The ECB could also expel Greece from the Eurosystem, but will it? And is this the best way of going about things? Arguably suspending Catalan autonomy and introducing direct rule from Madrid would be the quickest way of convincing those who are still in doubt that they want to vote for independence. Naturally the has to be an easier way of handling this problem than simply uping the ante, and hoping the whole Euro Area doesn't fall of a cliff in the ensuing uncontrollable and unpredictable chain of events.

Matteo Cominetta concludes his report as follows:

"We think after the Catalan elections on November the 25th the word
“independence” will become suddenly rarer in Mas’ rhetoric".

In fact here he is already somewhat behind the curve. The word "independence" only appeared momentarily in President Mas's rhetoric, around the time of the September 11 demonstration. Since that time Mas has only spoken of Catalonia as"a nation which is now arriving at full maturity", a nation which to express that maturity will need what he terms the "instruments of a modern state."

Now the language he is using is very conscious language, and very precise. It should not be interpreted, as radical separatists in Catalonia are already doing, as some kind of backsliding. What lies behind his point, and it is a theme he stresses continually, is that the term "independence" is something of a historical anachronism in the context of the modern EU and Euro Area.

What Catalonia wants are the same instruments of state as all the other nations in the Euro Area have, nothing more and nothing less, but this doesn't necessarily mean "independence" as many have traditionally understood the term. It does mean, however, and for example, that as long as there are still national central banks to intermediate regional (by regions here I mean places like France and Germany) financial systems, then Catalonia as a nation which in coming to full maturity wants one too.

Naturally all this looks like a huge mess, and a growing one across the Euro Area. That is just the way it is going to be, but people should have thought about all the longer term ramifications before creating the Euro, since whichever way you look at it, the Euro and its problems form the backdrop to what is now happening in Catalonia. If full political union had been achieved first, this kind of thing would never have started happening. But it is happening, and the will of a people to express themselves in a vote won't be stopped by simply telling them they can't have one, a point which President Mas iterates and reiterates constantly.

So, the 65 trillion dollar question is, does President Mas have the majority of the Catalan people behind him when he advances along this road to acquire the institutions which go along with statehood? My opinion is overwhelmingly yes. About 75% of those expressing an opinion in the polls are saying they want a vote on self determination, even though Madrid is stressing that this vote would be made illegal.

How then does all this now start to pan out? Well first we will have elections next month. President Mas's party, CiU, will win, and the only issue is really whether they have an absolute majority or not. Between 60% and 70% of the deputies in the new parliament will be in favour of holding a vote, and of voting yes. And on the question of the vote the CiU programme is very clear, one way or another it will happen, and indeed they are holding these elections exclusively to get the mandate needed for that vote. So if they didn't have one the electoral process would have been meaningless.

But in one sense Cominetta is right. The coming confrontation isn't going to be about money, it is going to come be the right to have a vote. In my opinion the outcome of that vote when it is held is not really in doubt. However, instead of going off into the realm of conjecture, and speculation, and coming up with ever more grotesque scenarios, I think it is better to await developments, since they surely won't be that long in coming. The only sensible way forward I see here is for the EU, when it takes Spain in for a bailout, to act as intermediary, take the head of the table, and organise negotiations between the two sides. I think if they can't do that, then the Euro may well come under threat much sooner than anyone is contemplating.

So to answer the my own question set at the outset - "can Mario Draghi keep his pledge?" I would say, go ask the Catalans. There are some problems that simple money printing won't solve, and the quantity of these problems in the Euro Area is growing, almost by the day.

Tuesday, August 14, 2012

So here's the 5 trillion dollar trick question. In an interesting article on the limitations of central bank monetary policy in the current environment, Reuter's Alan Wheatly made the following statement which caught my attention. "Central banks are rummaging through their toolkits because, despite slashing interest rates and buying vast quantities of bonds, they have signally failed to revive a global economy hamstrung by heavy debts and weak banks". But thinking about it for a couple of minutes, you could ask yourself why is this so?

Why is the global economy hamstrung by heavy debts and weak banks? Or put another way, why doesn't deleveraging happen, and the weight of debt reduce, and why doesn't the economy expand so the weak banks can once more become robust and healthy ones?

Short answer, it's the demand side stupid! The longer version was offered by Paul Krugman when he asked the ironic question, "To which planet are we all going to export?" Basically the demand needs to come from somewhere - unless of course you believe that "supply creates its own demand". What makes this crisis different from many of its predecessors is the global extension of the problem. If we were just talking about a few countries (as in the Asian crisis of 1998, which is so often mentioned in this context) then the answer would not be that hard, reduce currency values and export like mad to the non-affected countries. But in the current crisis, almost all developed economies are affected to one degree or another. The to one degree or another part is interesting, but it doesn't form part of what I am driving at here.

There are countries which are not so heavily in debt, and which do have a large growth capacity and a huge quantity of so called "pent up" demand - the so called Emerging Economies. But the simple math fails us. If we look at the first chart below the non "advanced" economies have been growing much more rapidly than the advanced ones since around 2002, so the potential is there.

But if we look at the second chart, these economies are still only around 40% of global GDP, so it is demand in 40% which is having to pull the other 60% with it. The interesting part is that in the space of a decade these economies have surged from 20% to 40% of the total. If the same trend continues by 2020 they could easily constitute 60%. Then things could be different, since we could have 40% of the total living from exporting to the other, faster growing, 60%. But we aren't there yet, which is why I think this decade will be a transitional one, one during which the developed economies (on aggregate) will struggle to find growth.

Nonetheless, emerging markets are growing fast, aided from time to time by an injection of liquidity from the developed world central banks. The IMF still expects the world economy to grow by 3.5% this year. Two issues cast something of a shadow over the immediate outlook. The first is the visible slowdown in Chinese growth, and the other is ongoing concern about the ultimate endpoint of the Eurozone drama in innumerable acts. The key point to appreciate about the second issue is that with “risk off” due to the European Debt Crisis, even the Emerging Markets are unable to exploit their huge potential for growth. Capital is not flowing into these markets in the way it did following the various rounds of QE in the US and even the LTROs in Europe. These impacts can be seen in the JP Morgan Global Composite PMI chart below.

Both QE1 and QE2 were followed by large surges in global activity, and even last November's LTRO from the ECB produced an unexpected turnaround that some would argue has only been putting off the inevitable. Certainly, the force of the LTRO impact wrong footed many of us, since it produced a stabilization of global activity which lasted all through the first half of this year (see the latest German GDP results for additional evidence).

The China factor is also important. It was curious to watch a world which had just slumped following the collapse of an unsustainable debt orgy hoping to save itself by egging another country on to repeat the performance. Naturally, history isn't a mere repetition of the same, and the Chinese conundrum contains plot elements not seen elsewhere, including an ultra important export sector, but still it is hard to see how so many people could have remained silent in the face of what appears to have been a crazed investment boom. Still, China is a long way from having its back broken, even if the spinal column does need a lot of straightening out. The awkward part is that the "Chinese correction" comes just at the wrong time as far as global growth is concerned.

In any event, the BRIC concept was always far too general. It is just based on population size and the presence of underdevelopment. The key factor for growth dynamics, as I keep arguing, is age structure, and in this sense India and Brazil look very different from Russia and China. Economic growth is partly about favourable demographics, and partly about institutional quality. Some EMs have favourable demographics, and some of these also are increasingly moving towards growth enhancing institutions. Others with favourable demographics are an institutional nightmare - Argentina is a good example, and others (like Ukraine or Belarus) have neither favourable demography nor positively evolving institutions, indeed in the two aforementioned cases it is unlikely they ever will.

What follows is a summary of my July manufacturing PMI report. The complete version can be found on Slideshare (here).

Manufacturing Visibly Slowing Across The Planet

We live in a globalised world. And what better illustration of this truism than the way in
which manufacturing activity is steadily slowing across the planet. In theory the
worsening conditions are a by-product of the Euro Debt Crisis, but in reality there
are a multitude of factors at work – the slowdown in China, exhaustion of a credit
boom in Brazil, a Japan which can’t export as much as it needs to due to the high
value of the Yen, a United States where the various rounds of quantitative easing
appear to have run out of steam.

But we also live in a world which is structurally in transition. The developed countries
are overly in debt (especially when we consider health and pension liabilities
looking forward) and ageing excessively. The emerging economies are
experiencing a massive demographic, cultural and economic transition. The so
called “Arab Spring” is just one example of this. Risk is being re evaluated, with
developed world risk rising, at the same time as risk perception of Emerging Economies improves.

So the paths are crossing. Recessions in the developed world will now be more
frequent and the recoveries shallower, while EMs will experience substantial catch
up growth, while the recessions will be much more modest than previously.

Having said this, it is still impressive to note the diversity even among the EMs. This month I was struck by the way manufacturing sectors in some countries (like Indonesia and Vietnam) are now evidently having a hard time of it, while in others (India, Turkey) they are managing to keep their heads just above water. But in all cases what is most notable in the report summaries that follow is the way in which exports are suffering, and export order books contracting, which suggests we have another six months or so of stagnation or worse staring us in the face.

Global manufacturing downturn gathers pace in July

The global manufacturing sector slid further into contraction territory at the start of the third quarter. At 48.4 in July, the JPMorgan Global Manufacturing PMI posted its lowest level since June 2009. The PMI remained below the neutral 50.0 mark for the second straight month, signalling back-to-back contractions for the first time since mid-2009.

Europe remained the main source of weakness during July, while the performances of the US, Brazil and much of Asia were at best only sluggish. Manufacturing PMIs for the Eurozone and the UK sank to their lowest levels for over three years. Within the euro area, the big-four nations fell deeper into recession, while Greece continued to contract at a substantial pace. Eastern Europe fared little better, with downturns continuing in Poland and the Czech Republic.

The ISM US PMI posted a sub-50.0 reading for the second successive month in July. Rates of contraction accelerated in Japan, South Korea, Taiwan and Vietnam, but eased slightly in Brazil and China. Brighter spots were Canada, India, Indonesia, Ireland, Mexico, Russia and South Africa, which all signalled expansion during the latest survey period. Manufacturing production and new orders both fell for the second month running in July, with rates of contraction gathering pace. International trade volumes, meanwhile, declined to the greatest extent since April 2009. Job losses were reported for the first time November 2009. With demand still weak and a sharp drop in backlogs suggesting spare capacity is still available, staffing levels could fall further in coming months.

Commenting on the PMI survey, David Hensley, Director of Global Economics Coordination at JPMorgan, said:

"Weak demand and the ongoing period of inventory adjustment pushed the global manufacturing sector into deeper contraction at the start of Q3 2012. Job losses were also recorded for the first time in over two-and-a-half years. Recent cost reductions are providing some respite, but this will be of little long-term benefit if underlying demand fails to pick up.”

Asia

Viewed as a continent, it is very hard to make generalitzacions about Asia. Japan is
among the oldest countries on the planet. Domestic demand is congenitally weak, and
exports struggle against the weight of an overvalued yen. The important point to notice
is that all last years predictions about Tsunami reconstruction bring a new lease of life to the country have proven to be ill founded. All the associated damage has done is produce more debt. And still the economy struggles to grow. This issue will doubtless become worse after the government introduces the long promised increase in consumption tax.

China is suffering from a real estate adjustment which influences internal demand, while the global trade slowdown harms the export sector. In addition, the country’s potential growth rate, after hitting double digits at one point, is now slowing steadily as China steadily moves from emerging economy to mature economy status. India continues to advance at rates which are not seen in most Asian economies these days, but the country has an endemic inflation problem which remains unresolved, and growth is also hampered by poor infrastructure and widespread corruption. The semi developed economies like South Korea and Singapore still struggle to overcome weak export demand, and even new emergers like Vietnam and Indonesia remain challenged to find growth at this point.

Japan

The Japanese economy slowed more sharply than expected in the April-June quarter as exports and consumer spending lost steam, raising the specter of further deceleration for the rest of this year.
Japan's economy grew strongly in the first quarter on increased government spending to aid in the rebuilding of areas battered by the March 2011 earthquake and incentives to boost sales of fuel-efficient vehicles. But fiscal policy appears no longer enough to offset the growing impact of the high yen coupled with Europe's persistent debt crisis and the resulting global slowdown on Japan's export-reliant economy.

July data from the Markit/JMMA manufacturing PMI survey confirmed the continuation of the April-June trend since it showed manufacturing output falling at the sharpest rate in 15 months, with both new orders and new export business decreasing at accelerated rates.

Commenting on the Japanese Manufacturing PMI survey data, Alex Hamilton, economist at Markit and author of the report said:
“Business conditions in Japan’s manufacturing sector took a turn for the worse in July, according to latest PMI survey findings. Factory output, new orders and exports all decreased at the fastest rates since April 2011, while input buying and backlogs also decreased markedly. These are worrying developments given the weakness of global demand at present.

China

In China the HSBC Purchasing Managers’ Index posted 49.3 in July, up from 48.2 in June, signalling Chinese manufacturing sector operating conditions only deteriorated marginally. Indeed, the month-on-month increase in the index, though small, was the largest in 21 months.

So while the Chinese economy is holding up far better than most of the hard landing people thought, the expectation was that it would be doing more than just holding up at this point in time. It was supposed to be both in the midst of a full-fledged recovery and driving the global demand chain. Chinese economic growth slowed to an annualised 7.6 per cent in the second quarter, its slowest pace since the height of the global financial crisis in 2009. And further data published last week indicated that it may need to do more to stop the rot which has now set in. Industrial production growth dipped to 9.2 per cent from 9.5 per cent in June, defying many analysts expectations for a rebound. Retail sales growth fell to 13.1 per cent from 13.7 per cent, while investment only managed to hold steady at a 20.4 per cent year-to-date pace. These are still large numbers, but for China, incredibly, they represent a slowdown. The fear is there may be worse to come.

“Final manufacturing PMI confirmed only a modest improvement of manufacturing conditions thanks to the initial effect of the earlier easing measures. But this is far from inspiring, as China’s growth slowdown has not been reversed meaningfully and downside pressures persist with external markets continuing to deteriorate. We still expect Beijing to step up policy easing in the coming months to support growth and employment.”

India

In India the HSBC Purchasing Managers’ Index posted 52.9 in July, down from the reading of 55.0 recorded in June and pointing to a continuing slowdown in the manufacturing sector.
In fact Indian industrial production slid in June for the third time in four months, with output of capital goods plunging the most on record.
Production at factories, utilities and mines declined 1.8 percent from a year earlier, after a revised 2.5 percent rise in May. Capital goods output, an indication of investment in plants and machinery, fell 27.9 percent.

Indian manufacturing has been struggling in recent months as inflation hovering above 7 percent has been eating into domestic demand and Europe’s debt crisis restricts exports. Price pressures from a drop in the rupee and the impact of a weak monsoon on crops forced the central bank to leave interest rates unchanged in July, breaking a trend towards reduced borrowing costs which extends from China to Brazil to Europe. The rupee has now slumped about 18 percent against the dollar in the past 12 month.

Headline inflation, which was 7.25 percent in June (the fastest pace among the world’s largest emerging markets) fell unexpectedly to the slowest pace in nearly three years in July following a sharp drop in fuel prices, but risks of a revival in price pressures may still discourage the central bank from lowering interest rates to spur economic growth.
The wholesale price index rose 6.87% in July from a year earlier.

Indian GDP rose 5.3 percent in the first quarter from a year earlier, the slowest pace since 2003, and both Standard & Poor’s and Fitch Ratings have warned they may strip the country of its investment- grade credit rating, citing risks including fiscal and current- account deficits.

"Manufacturing activity grew at a slower clip in July on the back of power outages and a moderation in new order inflows, with the weak global economic conditions dragging down export orders. Moreover, orders decelerated faster than inventory accumulation suggesting that the more moderate expansion in output will continue in the months ahead. The slowdown in order growth allowed manufacturers to reduce backlogs of work. Moreover, input and output prices decelerated, but inflation remains above historical averages."

Europe Heads Into Its Next Recession

The eurozone economy shrank in the second quarter, having flatlined in the first, despite continued German growth which looks increasingly fragile with every passing day out. Bailed-out Portugal saw its recession deepening with GDP diving by 1.2 percent on the quarter and 3.3% on the year, meaning that the threat of missing its deficit target this year is becoming increasingly real.

Figures released earlier had already showed deficit-cutting measures helped to shrink Greece's economy 6.2 percent year-on-year in the second quarter.
Italian data last week showed the economy contracted 0.7 percent quarter-on-quarter, compounding the difficulties for Mario Monti's technocrat government as it tries to avoid a bailout.
Spain's economy shrank 0.4 percent over the same period, pushing it deeper into recession.

As a result the currency bloc contracted by a quarterly 0.2 percent despite Germany eking out 0.3 percent growth. The storm cloud don't cease to gather, though, and just today the forward-looking ZEW sentiment index slid for a fourth month running. All the leading indicators for Germany now suggest looming contraction.

Thus, even as Europe’s leaders continue to fiddle around with the debt crisis, the economies of the Euro Area sink deeper into the mire. The latest round of PMIs suggest that the recession will become official in the third quarter, and at the present time there is no let up in sight.

Certainly progress is being made in terms of the liquidity and capital needs of Euro Area banks, and further moves to ease sovereign financing difficulties seem to be at hand, But competitiveness issues are still a long way from finding solution. There is no evidence to back the idea of a surge in German inflation, while VAT hikes in country’s like Spain continue to damage their relative cost position.

The ECB has raised market expectations considerably in recent days. In the short run such expectations have foundered on disappointment. In the longer run, however, the ECB is likely to have few unbreachable limits to its freedom of action. Movement by the EU and the ECB will require formal requests for aid and involve conditionality. When this happens the most likely policy move with be SMP reactivation by the ECB in the secondary market and EFSF purchases in the primary one. Finally a reminder: it is important to remember the Greek problem has not gone away, it is simply in limbo. The Troika have gone home for now, but they did leave a message, courtesy of the Ramones, “see you in September”.

Eurozone manufacturing recession deepens at start of third quarter

The final Markit Eurozone Manufacturing PMI fell to a 37-month low of 44.0, down from 45.1 in June. The PMI has now signalled contraction for 12 consecutive months. Widespread weakness was seen across the region, with almost all of the national PMIs at sub-50.0 levels. Only Ireland bucked the trend, seeing improved business conditions as its PMI hit a 15-month high. Rates of decline in Germany, France and Spain were either at or close to the steepest since mid-2009. Italy recorded the worst overall performance in three months, while Austria slipped back into contraction and business conditions in the Netherlands continued to deteriorate. Greece stayed rooted to the bottom of the PMI league table.

Casting a long shadow over the future, total new orders contracted for the fourteenth straight month, with the rate of decline the third-fastest for over three years. Greece and Spain recorded the steepest falls, while the big-three of Germany, France and Italy all posted sharp contractions. Declines in the Netherlands and Austria were much weaker in comparison, while Ireland saw new order growth hit a 15-month high. New export orders fell at the fastest pace for eight months, with intra-Eurozone trade particularly subdued. Only Ireland and the Netherlands reported increases in new exports. The German export machine remained firmly in reverse during July, recording the steepest drop in new orders of all countries and the fastest rate of decline since May 2009.

Chris Williamson, Chief Economist at Markit said:

“The Eurozone manufacturing sector’s woes intensified again in July. Output fell at the fastest rate since mid-2009, consistent with the official measure of production falling at a quarterly rate in excess of 1%. Manufacturing therefore looks to be on course to act as a major drag on economic growth in the third quarter, as the Eurozone faces a deepening slide back into recession.

Germany

The performance of the German manufacturing sector took another turn for the worse in July, with output and new orders both declining at the sharpest rates since April 2009. This led to a further drop in the Markit/BME Germany Purchasing Managers’ Index from 45.0 to 43.0 in July, its lowest level since June 2009.

July data also saw the thirteenth successive monthly contraction of incoming new business in the German manufacturing sector. This is the longest continuous period of falling new orders since the survey began in April 1996. Survey respondents frequently reorted an unwillingness among clients to commit to new spending, largely in response to the uncertain global economic outlook. New export work continued to decline at a steeper pace than total new business receipts in July. Manufacturers noted shrinking sales in Western Europe, alongside softer demand in Asia and the US. The overall decline in new export work was the steepest since May 2009.

Commenting on the final Markit/BME Germany Manufacturing PMI® survey data, Tim Moore, senior economist at Markit and author of the report said:

The German manufacturing PMI number slipped to bronze position in the ranking of the ‘big four’ eurozone economies during July, its lowest position for three years and indicative of a sharp deterioration in business conditions over the month. Manufacturers linked the latest setback to shrinking export sales and a general shortage of new work to replace completed projects. Output dropped at the steepest pace for over three years and job shedding was the most marked since the start of 2010.

Italy

Manufacturers in Italy continued to face a challenging operating environment at the start of the third quarter. A further contraction in demand led to lower output levels and the sharpest reduction in employment for 33 months, with a sharp and accelerated decrease in backlogs of work underlining the degree of excess capacity in the sector.

The Markit/ADACI Purchasing Managers’ Index dipped to a three month low of 44.3 in July, down from June’s reading of 44.6. The headline index has posted below the neutral mark of 50.0 throughout the past year, and was below the average recorded over the second quarter as a whole giving the impression that the recession may even be deepening.

Phil Smith, economist at Markit and author of the Italian Manufacturing PMI said:

“July saw the recession in the Italian manufacturing sector extend to a year. Moreover, the downturn was shown to have deepened as the PMI sank to its lowest level in three months, primarily reflecting a sharper reduction in staffing levels. A solid and accelerated decrease in stocks of purchases also dragged the headline index lower, and suggested that firms had grown more concerned about cash flow and were not anticipating a rise in production requirements in the near term.

Central and Eastern Europe

Czech manufacturing business conditions deteriorate further

The latest HSBC PMI report confirmed the ongoing weak downturn in the Czech manufacturing economy at the start of the third quarter. New orders and purchases of inputs by manufacturers both fell for the fourth successive month, while output remained stagnant. This is all in line with the fact that Czech GDP has now been falling for three successive quarters. The PMI remained below the no-change mark of 50.0 in July, continuing the pattern seen since April. The deterioration in overall business conditions signalled by the headline figure remained modest, however, as the PMI was little-changed at 49.5 from June’s 49.4.

Commenting on the Czech Republic Manufacturing PMI survey, Agata Urbanska, Economist, Central & Eastern Europe at HSBC, said:
“The PMI index changed little in July compared to June and still points to a slight deterioration of business conditions in the manufacturing sector. Among the index components, the suppliers’ delivery times improved (lengthened), offsetting worsening output, new orders and employment indices. We assess this combination as negative and remain cautious of downside risks. This is particularly the case in face of weaker than expected leading indicators in July like IFO and PMI in Germany. The PMI’s input and output prices indices show a further decline of inflationary pressures, and leave room for the central bank to cut its policy rate to a new record low later this year.”

Contraction of Polish manufacturing sector slows in July

HSBC survey data compiled by Markit indicated a near-stabilisation of business conditions facing Polish manufacturers in July. New orders declined at the weakest rate since March, while output fell only marginally since June and firms raised headcounts at the fastest rate since February 2011. The PMI recovered from June’s 35-month low of 48.0, posting 49.7 in July. That signalled a fourth successive overall deterioration in the business climate, but at only a marginal pace that was the weakest in that sequence.

Commenting on the Poland Manufacturing PMI® survey, Agata Urbanska, Economist, Central & Eastern Europe at HSBC, said: “The recovery of the PMI index, despite the fact that it still remains in contraction territory, is a positive following a month of activity data releases all surprising on the downside. The PMI still points to a marginal deterioration in business conditions in the manufacturing sector, but the pace of deterioration has slowed compared to previous months.

Turkish manufacturing output falls for first time in four months

The seasonally adjusted HSBC Turkey Manufacturing PMI dropped below the 50.0 no-change mark in July, posting 49.4. This followed a reading of 51.4 in June and signalled the first deterioration in business conditions since March. That said, the decline was only marginal. Both output and new orders decreased in July. New business fell for the fourth month in 2012 so far, following stagnation in June.

“Turkish manufacturing conditions deteriorated in July, falling into contraction territory for the first time since March. Both output and new orders fell, while new export orders recovered after a sharp decline in June. The pace of improvement was marginal, however.

United States

US PMI indicates slowest manufacturing expansion for nearly three years

Growth of the U.S. manufacturing sector slowed to its weakest pace in nearly three years in July, according to the Markit U.S. Manufacturing Purchasing Managers’ Index. At 51.4, down from the flash estimate of 51.8 and below June’s reading of 52.5, the PMI hit a 34-month low and signalled only a modest expansion during the month.

The volume of new orders received by manufacturers increased in July. The increase in total new work largely came from the domestic market, however, as new export orders fell for the second consecutive month, partly reflecting the ongoing economic crisis in Europe. Overall, new orders (both domestic and exports) rose only modestly, with the rate of increase weaker than the earlier flash estimate and the second-slowest since orders began rising almost three years ago.

Commenting on the final PMI data, Chris Williamson, Chief Economist at Markit said:
“The final reading of Markit’s U.S. Manufacturing PMI was even weaker than the flash estimate, indicating that manufacturers are currently reporting the weakest growth since September 2009.

“Producers are being hit by the ongoing euro zone crisis, slower global economic growth and increasing unease about demand in the home market as elections loom closer and uncertainty hangs over fiscal and monetary policies.“With order books barely growing in July as export orders fell for the second month in a row, the survey signals a real risk of manufacturing production falling in the third quarter unless demand picks up soon.

Brazil

Further declines in both output and new orders in Brazilian Manufacturing in July

July data signalled a further deterioration in manufacturing business conditions in Brazil, with survey respondents largely citing weak client demand. Both output and new orders fell for the fourth month running, albeit at slightly weaker rates than those registered in June, and firms reduced their workforces to the greatest extent in three years.

“The HSBC Manufacturing PMI stabilized in July, rising from 48.5 last month to 48.7. On the whole, the headline index and its key components remained below the 50 threshold, suggesting that the industrial sector in Brazil continued to contract in July. But at least this decline in economic activity appears to be losing momentum, with the very modest rise in the headline PMI index being led by improvements in both the output and new orders indices.”